Will the pension fund crisis lead to lawsuits?

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There’s an awkward question being asked around offices in the City right now: “Does it all feel a little 2008-y to you?” It’s easy to see why the current economic turmoil mirrors the prelude to the 2008 financial crisis: Sudden changes in market conditions are beginning to reveal problems with investment strategies previously considered safe.

This all comes after a decade of unusual economic conditions; incredibly low interest rates, lots of liquidity and investors with more capital looking for ever higher risk returns. Many companies are not yet well positioned for the changing market conditions and may be exposed to unwanted risks that they can no longer pass on to counterparties.

A cautionary tale can be seen in the recent pension fund crisis surrounding Liability Driven Investment (LDI) strategies. LDI strategies are largely executed by or for pension funds to manage their exposure to inflation and interest rate risk. Pension funds, especially defined benefit plans, must ensure that there is no long-term shortfall in the money that the funds must pay out to their beneficiaries. So they must generate returns that keep pace with inflation and interest rates. While traditional pension funds used bonds to hedge this exposure, LDI strategies use derivatives to do the same job.

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However, the shock of Kwasi Kwarteng’s mini-budget on September 23, 2022 caused government bond yields to quickly shoot through the roof. To maintain the same exposure, pension funds had to increase capital in LDI strategies. But the increase was so rapid that many could not fund it with cash, leading to a sell-off of illiquid assets they would not normally want to get rid of. As widely reported, this has led the Bank of England to buy UK government bonds to stabilize the market and reduce the need for funds to sell assets.

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LDI strategies are not necessarily bad. Properly implemented, they are a sensible way to hedge exposure, and only come under pressure in extreme market conditions. And that is why we see echoes of the questions asked after the financial crisis: did pension fund managers understand the risks? Were they ill-advised? Was there adequate governance and regulation to prevent reckless risk-taking? Will it lead to a lawsuit? The answers will depend on the specific circumstances, but in general exposure will be higher when funds had higher leverage. Making a quick turnaround and reducing their LDI positions is not really an option for pension managers, as companies would be forced to funnel money into pension plans at a time when corporate finances are already under pressure.

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So what does this panic in the retirement disco tell us about the risks that should keep the C-suite and everyone who manages investment strategies awake at night? The collision of an ongoing period of both financial and geopolitical instability simultaneously means that all bets are off. Risk management strategies need to be regularly reviewed and updated to adapt to market conditions. After weeks of chaos under Truss, things have stabilized somewhat with Sunak and Hunt, and interest rates are now not expected to rise as much as previously expected. But recent events highlight that boards, trustees and advisors must remain nimble to keep up with the new normal, or expose themselves to a real risk of loss and the litigation that may ensue.

Elaina Bailes is a Partner, Commercial Litigation, at Stewarts

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